Debt and Deleveraging

Kinza Bajwa
Manizeh Dossa
Ukasha Iqbal
Anam Zafar
Umair Suhail
May 24th, 2012

Research Objective

How We Proceeded?

Focus Area Development

Literature Review
Interviews
Model Analysis
Feedback sessions

Focus Areas

Debt Growth

Total debt relative to GDP in

the ten mature economies
increased from about 200
percent of GDP in 1995 to
over 300 percent by 2008.
Total debt increased by
about $ 40 trillion
In the four emerging
economies averaged 137
percent of GDP at the end of
2008

US
Mortgage
Lending
Low interest
rates

Globalized
banking

Sub-Prime
Borrowing

Securitization

Growth of
DEBT

Financial
Sector
leverage

Deregulation

Behavioral
Responses

US
Mortgage
Lending

Low Interest Rates and High House Prices The conditions were right
for people to achieve the American Dream. In the early 2000s, mortgage
interest rates were low. In addition, home prices increased dramatically, so
buying a home seemed like a sure bet. Lenders understood that homes make
good collateral, so they were willing to participate.

Cash out With home prices skyrocketing, homeowners found enormous

wealth in their homes. They had plenty of equity, so homeowners refinanced
and took second mortgages to get cash out of their homes' equity

Easy Access qualified for mortgages with little or no documentation. Even

people with bad credit could qualify as subprime borrowers.

Sloshing Liquidity People, businesses, and governments had money to

invest, and they developed an appetite for mortgage linked investments as a
way to earn more in a low interest rate environment.

Securitization

Deregulation

Banks to offload risks from Balance Sheet With increased

securitization of products , banks could do away with their role of monitoring
and regulating because the risk involved for them decreased with off balance
sheet activities

Securitized products to Subprime borrowers

Credit rating agencies awarded AAA rating due to complex models which

Inclusion of subprime
borrowers was due to high return yearning, guarantee of value recovery from
houses and nature of products being offered e.g. Collateralized Debt Obligation
didnt incorporate systematic risk but only unique risk and Moral Hazard issues

Government regulations lacked control due to which debt levels

increased considerably

US
Mortgage
Lending
Low interest
rates

Globalized
banking

Securitization

Growth of
DEBT

Deregulation

Behavioral
Responses

Sub-Prime
Borrowing
Financial
Sector
leverage

Bubble Bursts!

Real Estate Crash : With housing prices approaching peak ,mortgage

payment became difficult , while mortgage payment increased for adjustable
rate mortgages leaving borrowers with no option but to wait for foreclosure ,
renegotiate or walk away

CDOs default: Banks become unable to sell them off , money crunch ,
relatively better banks unwilling to lend , the mechanism collapses leading to
automatic and responsive deleveraging

Deleveraging

Micro Level: At micro-economic level, deleveraging refers to the reduction of

the leverage ratio, or the percentage of debt in the balance sheet of a single
economic entity, such as a household or a firm. It is the opposite of leverage,
which is the practice of borrowing money to acquire assets and multiply gains
and losses.

Macro Level: At macro-economic level, deleveraging of an economy refers

to the simultaneous reduction of debt levels in multiple sectors, including both
private sectors and government sector. It is usually measured by the decline of
the total debt to nominal GDP ratio in national account.

A significant episode of deleveraging in an economy as one in

which the ratio of total debt to GDP declines for at least three
consecutive years and falls by 10 percent or more

Deleveraging Phases and

Archetypes

First Phase: A phase for private deleveraging where first households,

corporations, and financial institutions reduce debt significantly over several
years, while economic growth is negative or minimal and government debt
rises. Second Phase: In this phase growth rebounds and government debt is
reduced gradually over many years. If the process is strictly followed, debt
levels are reduced and growth revives

Belt-tightening: In order to increase net savings, an economy reduces

spending and goes through a prolonged period of austerity.

High inflation: high inflation mechanically increases nominal GDP growth,

thus reducing the debt to GDP ratio.

Massive

default: this usually comes after a nasty currency crisis. Stock of

debt immediately decreases after massive private and public sector defaults

Growing out of debt: if an economy experiences rapid (off-trend) real GDP

growth, then its debt to GDP ratio will decrease naturally.

Deleveraging Current Status

US: Financial-sector debt has declined from $8 trillion to $6.1 trillion and stands at
40percent of GDP.US household debt has fallen by $584 billion, US households
would complete their deleveraging by mid-2013.

Deleveraging- Current Status

UK: For UK, on the other hand deleveraging just began. British financial
institutions also have significant exposure to troubled euro zone borrowers,
mainly in the private sector. Household debt has also increased because banks
have adopted a forgiving approach towards defaulters so essentially prevented
foreclosures.

Deleveraging Impact

Deleveraging - Impacts

Feedback loops gone wild: The most immediate risk is intensification of

the adverse feedback loops between sovereign and bank funding pressures in
the euro area, resulting in much larger and more protracted bank deleveraging
and sizable contractions in credit and output. Bank asset quality deteriorates by
more than in the baseline, owing to higher losses on sovereign debt holdings
and on loans to the private sector
Virtuous circles (and their accompanying animal spirits) give way to vicious
cycles, in which lower prices beget write-downs, which beget lower prices. And
on it goes. In the process, bad assets become toxic, especially for financial
institutions who, unlike other entities, have capital requirements that must be
met.

Impacts of deleveraging

Saving
out of
Income

Credit
Consum
ption

Supply

Asset
Prices

Gross
Fixed
Invest
ment

Global
GDP
Growth

Social
WellUnemploy being
ment

Social Well Being

Social Well Being

Deleveraging

McKinsey: Household debt grew faster than GDP in 10 mature

economies. Banks focus shifted from wholesale deposits to lending.
Five dimensions for analysis of the likely speed and extent of
deleveraging (level of leverage, growth of leverage, debt service
capacity, vulnerability to income shocks and vulnerability to funding
and interest rate shocks). Archetypes of deleveraging (most common:
episodes during which rate of debt growth is slower than nominal GDP
growth, or nominal debt stock declines; during these episodes of belttightening, the saving rate increased as borrowers reduced their debt)
Reinhart and Rogoff (2010): Historically, period of deleveraging follows
major financial crisis. Model studies behavior of GDP rates and GDP
growth, inflation, unemployment, bank credit availability and real-estate
prices during country-specific shocks and adverse global events.
Findings: in the decade following a financial crisis, real GDP per capita
is considerably lower. Leverage in the private sector decreases after a
financial crisis, resulting in lowered employment rates.

Literature Review

Goldberg (2011): Dynamic model of the persistent effects of a permanent

decline in firms ability to borrow on the labor market and consumption in
the context of the importance of a general equilibrium framework for
analyzing the economys response to deterioration in the quality of the
financial system. Findings: Changes in collateral requirements, which
result as a shortage of credit supply prevails following a financial crisis,
impact the labor market. Reducing the steady state value collateral value
of capital increases the extent to which firms decrease job creation
following a negative credit shock, and increases the persistence of
unemployment.
Devereux and Yetman (2009): Theoretical model of a balance sheet
channel for the international transmission of shocks. Findings: financial
deleveraging, generated by a downturn in one country, is spread around
the globe through interconnected portfolios regardless of trade linkages.

Literature Review

Hatzius (2008): Impact of increasing mortgage credit losses as

a result of declining home prices and the resultant reduction in
credit supply on real GDP growth. Findings: an overall
decrease in GDP and consumption results from decreased
construction activity, laid-off construction workers, lowered
home prices leading to a mortgage liquidity effect and depletion
of equity capital of leveraged financial institutions from losses
on mortgage credit, reducing the supply of credit to households
for consumption. Focuses on the availability of credit to private
nonfinancial borrowers, asserting that it is likely to have the
most direct effect on overall economic activity. From a policy
perspective, measures to boost the supply of credit are
promising tools for softening the economic downturn.

Model Objective and Methodology

Two-fold general equilibrium
model to study relationship
between
Firms credit availability
and macro-variables
(investment distortions,
consumption,
unemployment)
Credit availability and job
creation

Research Findings - 1
Credit

contraction adversely affects

investment (measured by total factor
productivity) and smoothness of consumption
Model of Deleveraging, Goldberg (2011)

The Model*

Fig a: net percentage of

surveyed domestic banks
that reported having
tightened the standards for
loans to both small and
large firms

Fig b: net percentage of

respondents who, conditional on
seeking credit in the previous
three months, reported more
difficulty in obtaining credit

The Model Studies

2.Unemployment
Deleveraging

Credit Contraction

1.Investment Distortion Consumption

Credit Contractions Effect on

Investment and Consumption:
Investment

Distortion is measured by Total

Factor Productivity (difference between
actual TFP and TFP assuming no borrowing
constraints)
Investment distortion is also reflected in the
gap between the marginal product of capital
and the interest rate; the gap is defined as
the finance premium firms are willing to pay
for an additional unit of borrowing.

GDP
As the following figure
shows, GDP is a function
of Investment,
Consumption and
Exports. Given GDPs
vulnerability to
deleveraging and the
emphasis of policy
makers on managing
growth, it is important to
see how contraction in
credit supply affects
investment and
consumption and
therefore Gross Domestic
Product at a macro level.

Research Methodology

To compare the steady-states of two economies that have different levels

of moral hazard but otherwise identical parameters, we compare state
properties of a benchmark economy to that of an economy where firms
ability to borrow is lower than in the benchmark. In the benchmark
economy, the pledgeability parameter is 1 = 0.62; the new value of is
taken to be as 2 = 0.49, reflecting a 13 percentage point decrease in
firms ability to borrow. This lower value for corresponds to
greater moral hazard and lower ability to commit to repayment.

The first row shows losses in measured total factor productivity

(TFP). Considering a decrease in the firms ability to borrow, if the
interest rates were held constant, TFP losses would increase by
0.33 percentage points (Partial Equilibrium). However, in order to
obtain steady-state equilibrium, the interest rate must fall,
because of the decreased supply of financial assets. Thus, with
general equilibrium, TFP losses increase by 29 percent, whereas if the
interest rate is unchanged, TFP losses increase only 13 percent.

The second row shows the average wedge between the

marginal product of capital and the interest rate. The third
row shows the standard deviation of the marginal product of
capital.
The average wedge between the marginal product of capital and
the interest rate increases about 69 percent. Likewise, the
standard deviation of the marginal product of capital increases
about 38 percent. Again, these increases are much larger than
the increases that would obtain if the interest rate were held
constant.

The final row in the Table illustrates how firms supply of financial
assets affects workers ability to smooth consumption
This measure is a standard tool in public finance and has been used by
Lucas (1987,2003) for a given worker, the thought experiment is what
share (1 - x) of the workers average consumption c provided in
perpetuity would generate the same level of utility as the workers
stochastic consumption stream?
To measure the workers ability to smooth consumption, an average
of (1 - x) must be estimated across all workers. x is not dependant
on wage but on the assumption of common risk aversion.

In the initial steady state, workers would be willing to give up

2.47 percent of their average consumption to have smooth
consumption
At the new steady state, because of the decreased
availability of financial assets, workers consumption is
riskier
The amount of average consumption that workers would be
willing to give to up to have smooth consumption increases to
2.82 percent
The change in investment distortions and workers
consumption smoothing can be better understood by
examining the change in certain quantities and prices

Research Methodology

If interest rates were held constant, firms equilibrium supply

of financial assets would decrease however, this will not be
consistent with equilibrium
To obtain equilibrium, the interest rate falls from 2.50 percent
to 1.44 percent
Of course, the equilibrium counterpart of a reduction in
the financial assets supplied by firms is a reduction in
the assets held by workers

The decrease in firms borrowing ability results in an in

crease in the steady-state liquid wealth of firms, as firms
require more liquid wealth to pursue investment
opportunities
However, the increase in liquid wealth is less than it would
have been if the interest rate were unchanged
This, again, reflects the endogenous decrease in the interest
rate. While the change in the interest rate does amplify the
distortions due to a decrease in firms borrowing ability, it
also dampens the decrease in capital

Research Methodology

The general-equilibrium amplification of investment

distortions can be further understood by considering how
distortions vary with the interest rate. For a given interest
rate, the steady-state investment distortions are
computed in Figure above. The steady-state distortions are
decreasing in the interest rate

When firms ability to borrow decreases, conditional on the

interest rate, steady-state investment distortions increase,
as shown in Figure above.

Result: The results clearly show that a permanent decrease

in the ability of firms to borrow leads to: increased capital
misallocation and decreased total factor productivity, an
increased wedge between the average marginal product of
capital, and increased riskiness of consumption

Credit Contractions Effect on

Unemployment

Data and Methodology:

Data used has been extracted from NIPA tables from the BEA,
from the Net Percentage of Domestic Respondents Tightening
Standards for Commercial and Industrial Loans and from the
Senior Loan Officer Opinion Survey on Bank Lending Practices
from the Federal Reserve Board and the National Federation of
Independent Business.

The economic
growth or GDP and
(therefore
unemployments)
affect on Human
Development Index
in the following
figure shows how a
decreased
economic activity
and unemployment
due to
deleveraging can
affect the general
development of an
economy as well

Research Findings 2
There

is a positive relationship between

credit contraction and decrease in job
creation
- Borrowing Constraints, Collateral
Functions, and the Labor Market, Julio
(2011)

The Model*

Objective is to analyze the effect of credit contraction on

unemployment which proposes to explain the implications
of a sudden increase on frictions associated with hiring
workers i.e. the ability of firms to create jobs and the
adverse affect triggered in human development and
social indicator front
The model has two types of agents: Households provide
labor and funds, Capitalists own the capital stock
In the model, firms can finance their operations through
the use of debt or equity

To combat against the possibility of default loans are

subject to the collateral requirements
A negative credit shock tightening of credit conditions
reduces the amount the firm can borrow against its
collateral
A contraction in credit will however, improve the
bargaining position of firms by increasing the sensitivity of
the firm's surplus to changes in wages
Therefore, small changes in wages will likely generate
larger movements in labor market variables, in particular
employment and job-creation

Credit Contractions Effect on

Unemployment: Quantitative Analysis

The functional forms for preferences, adjustment

costs, and vacancy costs are presented in Table
following Perri and Quadrini (2011) and Chugh
(2009).
The values of the parameters of the baseline case
can be seen in Tables 2 and 3.

Impulse Response: Total Factor

Productivity (TFP) shocks
Figure 3 shows the response
of some of the variables of
the model to a one standard
deviation positive shock to
aggregate productivity.
Following a positive
technology shock firms
increase their hiring, with
vacancies increasing on
impact almost by 3%. At the
same time, unemployment
decreases, causing an even
larger increase in labor
market tightness.

Impulse response: Credit Shock

Figure 4 plots the response to a one
standard deviation negative shock
to credit market tightness. Firms'
leverage is exogenously
decreased and firms are able to
borrow a smaller fraction of their
collateral. The credit shock
decreases the firm's ability to
access funding and the firm
responds by decreasing
investment, employment, and
borrowing. The reduction of
investment decreases future
levels of the capital stock, which in
turn further decreases the firm's
ability to borrow. The persistent
reduction in investment follows
from the shock: since the credit
constraints are tighter for several
periods it in turn causes a
prolonged increase in the
marginal cost of investing.

Result

Credit shocks affect fluctuations of key labor market variables like

unemployment, vacancy posting, and labor market tightness. This
results from the fact that while wages are very sensitive to productivity
shocks, credit shocks are not. Because changes in collateral
requirements do not translate into large changes in wages, these
disturbances have large effects on the ability of firms to create jobs. In
addition to this, if firms face, on average, tighter collateral constraints, then
the response of labor market variables to financial shocks is greater.
In other words, reducing the steady state value collateral value of capital
increases the extent to which firms decrease job creation following a
negative credit shock, and increases the persistence of unemployment.

Pakistan and Global Deleveraging

Mature Economies Debt-to-GDP Ratio =

Pakistan Debt-to-GDP Ratio = 70%
200 to 300%

Pakistans Debt

Pakistan Outstanding
Public Debt (June 2010)
USD108.67
More than half is foreign
debt
This is around 70% of GDP,
coming down from more
than 95 percent of the GDP
in 2000/01.
Foreign and domestic debt
each constitute about a third
of the annual GDP.
Debt has increased
continuously in absolute dollar
terms over the last 16 years.
The rate of increase was
quite sharp over the years of
the financial crisis, i.e.
2007/08 to 2009/10.
Since the rate of inflation in
Pakistan has been much
higher than the rate of
depreciation of the Pakistan
rupee against the US dollar,
the rate of growth in nominal
GDP has exceeded the rate

Why Pakistans Debt is a Problem

Pakistan does not
possesses sufficient
foreign currency
reserves to service
IMF and other foreign
debt
Pakistani Rupee is not
a desirable currency
people wish to hold
Government raises
inflation to service debt
(minting money)
Rupee-Dollar
exchange rate rises
further, impacting
future ability to service
debt, effective rate of
interest balloons

Impact of European
Deleveraging

Economic Activity in Pakistan

Most of the growth that did occur can be attributed to the services sector,
while the production sector, impeded by various factors, could not make a
significant contribution, and owing to various exigencies such as energy
shortages in the industrial sector, flood effected crop loss in the agricultural
sector, lower commodity prices in the global markets and lowered exports
demand from China and Europe, economic activity has been affected more
in real terms than through financial linkages with mature economies.

Interest Rate
High Interest Rate
encourages
household saving
and decreases
consumption,
impacting overall
economic activity

Business sectors suffer high financing costs which contribute to their

high costs of production, making competing in the global arena with
low-cost producers such as Bangladesh in textile for example
difficult. This further clamps down GDP growth.

Economic Activity in Pakistan

High
Production
Costs

Businesses
Unprofitable

Non-Performing
Bank Loans

Credit
Contraction

State of Investment in Pakistan

NPLs

Credit
Contraction

Unhealthy
Bank
Share Prices Fall
Balance
Low Investor
Other investments
Sheets;
Confidence
eg gold
Foreign Investment
Pulls out

Exports

Due to global deleveraging, there is decreased global demand. Economies like

China and Europe produce less demand for Pakistani exports. As a result, we see
a trend of diminishing export activity post crisis.

The Social Implications

Social Indicators

Policy Response Focus: Global

The deleveraging process that began in 2008 is proving to be

long and painful
To overcome this economic malfunction, progress has to be
made on various fronts including growth , restructuring , debt
reduction , banks and regulations, inflation, austerity among
other
For business leaders trying to navigate the new world of debt
reduction, understanding the course of deleveraging is of
critical importance. Although growth in the time of deleveraging
may be slower and more volatile in some countries, there are
also clear opportunities to invest ahead of demand and exploit
pockets of growth even within slowly expanding economies
McKinsey Global Institute

The economies of Sweden and Finland have experienced a

turnaround in growth, by decisively resolving the financial crisis
arising from severe recessions spurred by decline in private
sector debt whilst a sharp increase in public sector debt. The
deleveraging episodes of both Sweden and Finland are
highlighted in the Table below

Today, the United States is following the Swedish and Finnish examples
most closely and may be two years or so away from completing private-sector
deleveraging. The United Kingdom and Spain have made less progress
and could be a decade away from reducing their private-sector debt to
the pre-bubble trend. McKinsey Global Institute

Six Critical Markers Identified by

McKinsey Institute
Stability

of the banking system (Basel III)

Long term fiscal sustainability
Structural reforms
Rising exports
Rising private investment
Stabilization of the housing market

Policy Response Focus: Pakistan

Given the scenario in Pakistan, where household consumption

is low and business activity is impeded by a myriad of factors
including low credit supply, a study by the McKinsey Global
Institute classifies this as a belt-tightening archetype of
deleveraging
Compared to other regions of the world, Pakistan is still well
placed to respond to shocks with countercyclical fiscal policy,
but many economies have higher public debt levels than they
did at the end of 2007. And as real policy rates are
considerably below historical averages in all economies in the
region in March 2012, the room to ease monetary policy is also
less than before the global financial crisis. - World Economic
Situation and Prospects 2011

Improving Budget Allocations

The burden of debt servicing is borne by the tax payers of the country. The
tables below, extracted from the Budget Reports 2011-2012 of the
Government of Pakistan, Finance Division, give a fair approximation as to
the proportion of budget - 40% - 50% - allocated towards debt serving.
The debt situation must be controlled in Pakistan otherwise it can lead to
worsening of inflation rates. This is because public debt severely crowds
out private debt; and the government in order to repay internal and
external loans must resort to printing rupees if the debt servicing amount
cannot be completely raised through taxation.
This practice has resulted in inflation rates skyrocketing in developing
countries like Nigeria and Argentina.

Curbing Tax Evasion

The aforementioned problems directly link to tax evasion as majority of
Pakistans tax revenue arises from indirect taxes and taxes on
corporations. Indirect taxes are regressive in nature and hence a burden
on the lower and middle income groups of the population.
In order to service and repay external and internal debt the government
increases the rate of taxes levied rather than expand the taxpayers base.
Pakistan's tax-to-GDP ratio declined from 9.1 percent in 2008-09
(registering the same ratio in 2009-10) to 8.6 percent in 2010-11 while
revenue collection, the President proudly announced in his speech to the
joint sitting of parliament, doubled from Rs 1000 billion to about Rs 2000
billion since 2008. - Business Recorder. (2012)

Structural adjustments
The debt-to-GDP ratio of Pakistan is hovering close to 70%. This is a
matter of concern because of the impending negative exchange rate
implications which may result from an increasing debt-to-equity ratio.

Political instability and the capital flight of Foreign Direct Investment

following the stock market crash from approximately 15,000 to 500
basis points in 2008 had shocked Pakistan's economy. The above
coupled with high inflation resulted in a crash in the value of the
Rupee, which fell from 601 USD to over 80-1 USD in a few months in
2008. It was speculated then that, for the first time in years, Pakistan
may have to seek external funding as Balance of Payments support.

Consequently, S&P lowered Pakistans foreign currency debt rating to

CCC-plus from B, just several notches above a level that would indicate
default. Pakistans local currency debt rating was lowered to B-minus from
BB-minus. Credit agency Moodys Investors Service cut its outlook on
Pakistans debt to negative from stable due to political uncertainty, though
it maintained the countrys rating at B2. Economy of Pakistan (2008),
Wikipedia

The local industries remain depressed due to the ongoing energy crisis
and absence of a strong regulatory framework. With inelastic imports,
high global commodity prices, and a depreciating currency, the trade
deficit of Pakistan keeps on widening. This traps the country in a
vicious cycle of circular debt - the growing trade deficit increases the
debt-to-gdp ratio, which follows by a depreciation of the currency and a
disproportionate amount of budget directed towards repayment of
interest and loans

The following Table compares the debt-to-GDP ratios of the

developing economies of the East Asia region with Pakistan.
Although the debt-to-GDP ratio of some mature economies,
including the US, is around 200 % it is not an appropriate
benchmark because of strong currency ratings of the dollar.
Although the debt-to-GDP ratio of some mature economies,
including the US, is around 200 % it is not an appropriate
benchmark because of strong currency ratings of the dollar.

Conclusion

Hence, the orientation towards policy making should be such

that the defects on the Balance of Payments must be reduced
in order to break from the cycle of interest and loan repayments
and lower the debt-to-GDP ratio.
Structural changes must be introduced in fiscal policy geared
towards the growth of local manufacturers and industries.
Currently, the Non-performing loans, especially in the textile
sector, and credit contraction by banks has further curbed
growth in any export industry.
A dual effect policy is a must to reduce trade deficits. With a
growth in the economic productivity of the country, and falling
levels of unemployment, the GDP per capital of the economy
would rise and growth would outstrip inflation

With the onset of FDI, the currency of the country would

appreciate and allow for further strengthening of the Balance of
Payment position and would be visible through other social
indicators discussed earlier.
All in all, a revival of the local industries and injection of budget
into development education, health, and infrastructure to
name a few is absolutely necessary for Pakistan to break
away from its state of stagflation induced by cycle of debt.

Q&A